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It almost seems as though the forces of nature are conspiring to drive down the stocks of online brokers. The spring cooldown in tech stocks led to a sharp decline in trading volume, which translates pretty directly into lower commission revenues for firms such as E*Trade Group (EGRP), Ameritrade (AMTD), TD Waterhouse (TWE), and Charles Schwab (SCH).
Some evidence indicates that the bread-and-butter clients of online brokers, frequent traders -- as opposed to professional Wall Street types or semiprofessional daytraders -- have been the quickest to jump to the sidelines. Some analysts believe these poorer but wiser customers may never return to their click-trading ways.
And that's just part of the problem. Rising interest rates, which continue to foster market uncertainty, also eat into the brokerages' net interest income, in part because investors are less willing to buy stocks on margin. Moreover, investors are revolting against Internet companies that seem to be throwing money away on advertising -- and anyone who watches TV knows that online brokers are among the biggest culprits when it comes to that.
"SUCKING WIND."
Meantime, regulators are starting to grumble that online brokerages haven't done enough to protect customers against service outages or unsuitable investments, and have promoted undisciplined trading strategies in their advertising campaigns. Hovering in the background are concerns about new competition from traditional firms such as Merrill Lynch on one side, and on the other, a new crop of deep discounters ready to drive commissions to zero. "A lot of online brokers are really sucking wind," says Gary Craft, who follows the e-finance sector at Deutsche Banc Alex. Brown.
Interestingly, Craft's is the minority view, at least among Wall Street analysts. Despite the recent gloom, most analysts say that now isn't such a bad time to add a leading online brokerage to your portfolio. In a May 25 report, while lowering his second-quarter earnings estimates and noting that online brokers could dip an additional 10% to 20%, Pacific Crest Securities analyst Tim Butler wrote: "For investors with long-term horizons, we believe that now is an ideal time to establish (or add to) positions in e-finance leaders like Schwab and E*Trade."
Such a statement is hardly surprising given that it's part of the job of sell-side analysts to offer a best-case scenario for the stocks they cover. But it may not be such bad advice. Investors who believe in buying leading companies in a growth industry when sentiment has turned negative should take a closer look at online brokerages. These stocks, while far from cheap in conventional terms, have been on a roller coaster all year and are now in one of their lowest dips. Most are 60% or more off their highs.
FALL REVIVAL?
Yet the industry should experience dramatic growth in coming years. From around 10 million online accounts now, there'll be 20 million within three years, predicts Forrester Research. Yankee Group forecasts 30 million. Firms such as E*Trade and Ameritrade are only just breaking even now, but that's because they're spending tens of millions on marketing to enlarge their customer base and on acquisitions to diversify their revenue streams.
Absent that spending, "their business models are definitely working," says Richard Zandi, an analyst with Donaldson, Lufkin, & Jenrette. And the flexibility these companies are gaining by adding new business lines will help them in the long run, when the economy inevitably turns down.
Analysts think that as soon the Federal Reserve has finished raising interest rates and the summer months (a period of seasonal weakness for the brokerage industry) have passed, frequent traders will be back in the market and volumes will rise again. While the spring slide in tech stocks was painful for many investors, it probably wasn't damaging enough to dampen their desire to trade. "It has become a lifestyle for people," says John Garrity, associate research director of Investec Ernst & Co. "Things would have to get a lot worse to change that." (See BW Online, "Diary of a Day Trader, Eight Months Later".)
RISKY TIME.
Keep in mind that even the optimistic sell-side analysts don't think online brokerage stocks are going anywhere soon. Most agree that these companies could fall further. "They could have a little bit more downside as people still adjust to the lower volume," says Zandi. But he says he's "very bullish" when he looks out a year or longer.
To be sure, this would be a risky time to buy in -- and all bets are off if stocks really crater. But as long as you believe the general trend of the market is up, and that investing has replaced baseball as the national past-time, then leading online brokerage firms such as Schwab and E*Trade should have a bright future -- or at least not as bleak as the outlook now seems.
Amey Stone covers investing for Business Week Online
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